I’d put this quote from Buffett as one of the top 3 most important investing lessons (if not the top) of all time:
“If the choice is between a questionable business at a comfortable price or a comfortable business at a questionable price, we much prefer the latter.”
The holy grail in investing is to find a “comfortable business” at a “comfortable price”. That’s hard, to put it mildly. Buffett’s mentor and right-hand man, Charlie Munger, calls them “lollapalooza” events. Here’s an observation from him that tells us how rare these events are:
“How many insights do you need? Well, I’d argue that you don’t need many in a lifetime. If you look at Berkshire Hathaway and all its accumulated billions, the top ten insights account for most of it. And that’s with a very brilliant man – Warren’s a lot more able than I am and very disciplined – devoting his lifetime to it. I don’t mean to say that he’s only had ten insights. I’m just saying that most of the money came from ten insights.”
In this worldview article, we’ll go through how Buffett analyzes a business to deem it comfortable or not. If you find a company that has a distinct competitive advantage, has a well-thought-out way to protect that competitive advantage over time, with a competent Management team to make sure the first two characteristics remain intact, you’re onto something comfortable.
Then we’ll go into some Accounting metrics that measure this level of comfort. We’ll make the link between “business analysis” and Valuation and we’ll end it at that, for now. Valuation will be the follow up article. Otherwise our brains will explode.
What is a Comfortable Business?
Buffett tells us that finding a Comfortable Businesses is more important than finding a Comfortable Price. My experience confirms this. More often than not, I’ve lost money by buying companies that were extremely cheap. That’s because in most cases those companies were cheap for a good reason – they weren’t expected to grow, and they didn’t.
So, what does Buffett look for in a Comfortable Business? Here’s what he says:
“Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag…”
He goes on to say:
“The key to investing is determining the competitive advantage of any given company and, above all, the durability of the advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors. The most important thing for me is figuring out how big a moat there is around the business. What I love, of course, is a big castle and a big moat with piranhas and crocodiles.”
This is the source of why The Buylyst breaks its thesis down into these 3 components:
- Competitive Advantage.
- Durability of Competitive Advantage.
- Management Quality.
The Buylyst maps out The Buffett Way.
How do we gauge whether or not a business has a Competitive Advantage? This is the “castle” part of Buffett’s analogy. At The Buylyst, we break the castle down further into 3 components:
- What is the company’s Core Competency? We like it when the core competency is easy to define. In some cases (like Vestas), their core competency is more or less the product they sell – Wind Turbines for large Utility projects. In other cases, the core competency may be slightly esoteric – like Apple, whose core competency is the seamless end-to-end software-hardware ecosystem. No other company does that yet.
- Are the company’s products/services better or cheaper? In Finance or Consultant-Speak, we would label these as “cost-leadership” or “product differentiation”. But you get the point. Is the company trying to make the best product/service out there? Or is it trying to produce the cheapest product? We prefer the former. But here’s a good rule of thumb: A company that tries to do both – be a cost-leader AND a product-differentiator – ends up doing neither.
- What do historical revenue and margin growth numbers tell us? We need some numerical evidence that whatever the company is doing – it’s core competency and its decisiveness on cost-leadership or product-differentiation – is working. Revenue growth and trend in EBITDA margins are good data points.
How do we know if a company’s Competitive Advantage is durable? How does a firm protect its competitive advantage? This is the “moat with piranhas and crocodiles” part of the Buffett analogy. We break this down into 3 components:
- Competition/Threats: This is where we map out the current competitive landscape AND potential threats in the future. Who are the barbarians at the gate determined to chip away at our company’s profits?
- Protection/Moat: This is the meat of this section. How does a firm protect itself from those barbarians – current and future? Some firms can fall back on Intellectual Property rights, while others may have a scale advantage that competitors can’t match. Scale matters a lot for cost-leaders. But it also matters for differentiators – a larger user-base begets an even larger user-base. And the effect – especially in software-related products – manifests as a “network effect” in which all users gain in terms of “experience” if more users join. Adobe and Facebook are good examples of this.
- Cash Flow Volatility: The financial effect of 2 points above is Cash Flow Volatility. We like to gauge if cash flow – like EBITDA or Free Cash Flow (both will be discussed below) – will swing a lot because competition/threats would eat into cash flows. The simple reason is that if cash flows wallop about wildly, the less reliable it’s valuation may be. Investors as a whole would demand a higher “risk premium” for the stock because of the level of uncertainty. A company with less competition and a strong Moat will have stable and growing cash flows. Stable and Growing are music to the market’s ears. We’ll cover this more in the next section on Valuation.
How do we gauge Management Quality? This is hard because as small, retail investors we don’t have access to Management. But we can look for clues, which we break down into 3 components:
- Strategy & Action: How is Management protecting the company’s competitive advantage? How is it widening the Moat? How does it think about the competitive landscape? Where and how will it spend money? This last question – how Management will allocate shareholder capital – is its main job according to Buffett. They must put their money where their mouths are, and where their mouths are should make sense to us.
- Return on Equity: Historically, the best measure of Management’s Capital Allocation skills is Return on Equity (ROE). It’s a flawed measure but when used comparatively across firms in the same industry, it offers some clues about the firm and its Management. Simply put, this measures the average return on shareholder capital. Over the long term, Munger says, a company’s stock return will reflect ROE. Generally, at The Buylyst we like firms that have shown ROE above 20% historically, or ones we expect will show that sort of ROE in the next 2-3 years.
- Sustainable Free Cash Flow: This is the catch-all measure of our entire analysis. This is how much value the firm is ultimately creating annually.
Now let’s map all this to numbers. Our end-goal is to arrive at a reasonable valuation for the company and its stock. That gives us a marker, a compass, that guides our decision about whether the price we’re seeing in the market is comfortable or not. But first, let’s get to Free Cash Flow.
Let’s Link it to Valuation.
The link to valuation is through a company’s financial statements. We have all that subjective stuff discussed above, which I’ll recap here to make things easy:
- The Castle: Does the firm have a distinct Competitive Advantage?
- Does it have an easily identifiable Core Competency?
- Does it sell products/services that are decidedly Better or Cheaper?
- Have Revenue and EBITDA margins grown over the past few years?
- The Moat: Is the firm’s Competitive Advantage durable?
- How does it stack up against its present competition? And future threats?
- What is the main protection against these threats? What is the Moat?
- Will cash flows become more or less volatile? Preferably, less volatile.
- The Generals: Is Management doing a good job?
- What is its strategy? How is it allocating money? Is it focused on the right things?
- What is the firm’s ROE? Does it suggest that Management has done a good job?
- What is the firm’s expected SUSTAINABLE Free Cash Flow? This is the crux.
Free Cash Flow – which we’ll calculate together below – is the end result of all this analysis. Has the firm generated positive or negative Free Cash Flow in the past? That is good information. But our job is to combine all the points above – Competitive Advantage, Moat, and Management Quality – to estimate FUTURE Free Cash Flow. Now, Free Cash Flow is an annual number. Most analysts try to “forecast” this number on an annual basis going forward. We think this is futile. Firstly, forecasting is a loosely used term. Nobody can forecast with any degree of accuracy. I mean, can you really expect an analyst to estimate Free Cash Flow in the year 2029? That’s false precision. The best we can do is this: What is a believable level of AVERAGE Free Cash Flow that the firm can generate over the next few years? What level of Free Cash Flow is SUSTAINABLE? Ok – let’s get to work.
I’ll go over each line item in The Buylyst Valuation Details page and link it to The Buylyst Thesis template discussed above. As a reminder, here’s a typical Valuation details section for investment ideas at The Buylyst.
You’ll notice that there is a separate column for Sustainable numbers Those are assumptions based on all the subjective analysis discussed above. On the right, we show columns of historical numbers. Those are real, shown for comparison purposes. Normally, with companies the we’ve analyzed, the Sustainable numbers are equal to or higher than historical numbers. This should be the case. Why invest in a deteriorating story?
Now let’s go through this line-by-line. I’ll give some context and also point out where you’ll find these numbers in a company’s financial statements.
The Cash Flow Waterfall.
REVENUE: Found in the Income Statement.
This is the easiest variable to decipher. I like to break it down into a simple equation: Revenue = Price times Volume. If a company has a distinct Competitive Advantage, revenue should be stable or increasing. Now, if the firm focuses on making better products, then it should have some pricing power. That means the firm can increase prices in the future without sacrificing much volume. That’s great. Apple is a good example. But if the firm focuses on making the cheapest products, then the firm doesn’t have pricing power. Then scale is paramount. And if the firm is successful in making the cheapest product, the source of revenue growth must have come from increases in Volume, not Price. Walmart is a good example. At The Buylyst, we prefer firms with some Pricing Power. That gives us more confidence to assume a higher revenue number in the Sustainable column.
Minus COST OF GOODS SOLD: Found in the Income Statement.
This is almost exactly as it sounds. But this is just the variable part of the cost equation. So, to make a car, this is the cost of metal, parts, running cost of the factory etc. – essentially everything non-labor.
Minus R&D & COST OF LABOR: Found in the Income Statement.
This is a weird one because it has two different types of costs:
- Research and Development: Sometimes, firms “expense” these costs instead of “capitalizing” them. This is an Accounting nuance that we don’t need to get into here. But in the Income Statement, you should be able to see an “R&D” or “Research & Development” line item.
- Cost of Labor: This is exactly what it sounds like – salaries and other employee compensation. But sometimes, this line item is either:
- Not lumped in with R&D Expense or…
- In a separate line item on its own or…
- Lumped in with SG&A (next).
Minus SELLING, GENERAL & ADMINSTRATIVE EXPENSES: Found in the Income Statement.
These are all the other operating costs of running the business. Flights, hotel rooms, overhead costs, rent etc. Usually, this is labelled clearly as a separate line item.
Minus OTHER: Found in the Income Statement.
This is a wildcard. It could mean anything. But the number is usually negligible, so let’s not worry about it too much.
Plus DEPRECIATION & AMORTIZATION: Found in the Statement of Cash Flows – Cash Flows from Operations section.
This is a big one. Now we’re moving over to the Cash Flow Statement from the income statement. You may see a Depreciation and Amortization line item in the Income Statement. But don’t use that. That’s based on Accrual Accounting. In fact, sometime Depreciation & Amortization is included in the Cost of Goods Sold number. So, use the one in the Cash Flow Statement instead. Ironically, this is a non-cash charge, which is why we add it back. It’s not a cash cost to the firm. It’s supposed to factor in the cost of wear-and-tear of the firm’s Property, Plant and Equipment. But it’s an Accounting assumption. We use another charge down the line to account for this wear-and-tear.
EBITDA stands for Earnings before Interest, Taxes, Depreciation and Amortization. It is a commonly used proxy for Cash Flow. The Finance industry likes it because it’s supposed to give us an “unadulterated” picture of a firm’s earning power. I say “unadulterated” because the rest of the costs not factored into EBITDA – like interest and taxes – are of the “non-operational” variety. That may be true, but those costs do exist. So, while EBITDA is useful, it’s not the best measure of a firm’s earning power. However, The Buylyst uses EBITDA margin. We think this is a predictable number that can be “forecasted” with a reasonable degree of confidence. In the Sustainable column, instead of making assumptions about Cost of Goods Sold and other costs, we use EBITDA margin and our assumption of a Sustainable Revenue number to derive a Sustainable EBITDA number.
Minus MAINTENANCE CAPITAL EXPENDITURE: Found in the Statement of Cash Flows – Cash Flows from Investing section.
This is where we account for that wear-and-tear of property, plant and equipment. This is a real cash number. But there is one niggle. Maintenance Capital Expenditure isn’t actually reported as a separate line item. It’s included within total capital expenditure, which is often reported as “Additions to Property, Plant and Equipment”. Here’s the caveat: we need to make a subjective assumption about the proportion of “Additions to Property, Plant and Equipment” that is Maintenance. At The Buylyst, we assume about 50% if we don’t have any other information. But we try to get hints of this from the company’s earnings calls, which we then square with the Depreciation & Amortization number. That’s because Maintenance Capital Expenditure is supposed to be the amount of cash required to just keep the firm in business – without growing.
UNLEVERED CASH FLOW: Calculation.
When we deduct Maintenance Capital Expenditure from EBITDA, we get Unlevered Cash Flow. This number isn’t so important, but it is a better quality number than EBITDA.
Minus INCREASE IN WORKING CAPITAL: Found in the Statement of Cash Flows – Cash Flows from Operations section.
This is a cash number. It’s a temporary cash cost that comes from temporary mismatches between Receivables, Inventory, Payables and other current liabilities. Imagine selling something on credit – if you don’t receive that payment by the time the books close, it’s essentially a loan to the customer, which is capital. This number is usually a sum of many line items in the Cash Flow from Operations section. All those line items are housed under a title like “Changes in Operating Assets/Liabilities”.
CASH PAID FOR INTEREST: Found in the Statement of Cash Flows footnotes or in the Notes section of the 10K/Q.
This one is not fun because it’s often not reported in the Cash Flow Statement. That means going into the Notes section of the 10K to look for that one weird line that says something like “in 2016, 2017 and 2018, ABC Company paid $X, $Y, and $Z in interest”. But about half the time, this number appears as “Cash Paid for Interest” in the footnotes of the Cash Flow Statement! I realize I’m a hopeless nerd when that footnote brings a genuine smile to my face.
CASH PAID FOR TAXES: Found in the Statement of Cash Flows footnotes or in Notes section of the 10K/Q.
Ditto from Cash Paid for Interest. This Cash Tax number will be very different from the Tax number in the Income Statement. You can thank the vagaries of Accrual Accounting and US GAAP for that.
DISCRETIONARY CASH FLOW: Calculation
This is an important number. This is the cash available to management to do what it wants. If we go back to The Buylyst investment thesis, this is where the Management section begins. What will Management do with this cash flow?
Minus GROWTH CAPITAL EXPENDITURE: Found in the Statement of Cash Flows – Cash Flows from Investing section.
This is where we hope Management spends a lot of money. The most comfortable company is one in which Management re-invests a lot of cash to:
- Strengthen the Castle.
- Widen the Moat.
Now, here’s the caveat. Usually, we subtract this number to arrive at Free Cash Flow but there is a niggle. This money is supposed to be recovered – Management spends it to realize some yield out of it. This is supposed to be additive to Return on Equity. However, that yield is not guaranteed. And to be conservative, we subtract this number. But there 2 exceptions:
- If Capital Expenditure is funded by debt. In that case, there will be some extra cash outflow in the form of Cash Paid on Interest.
- We are fairly confident that this re-investment will yield returns quickly. This is rare.
CASH PAID FOR ACQUISITIONS: Found in the Statement of Cash Flows – Cash Flows from Investing section.
This is usually listed out as a separate line item. And it’s lumpy. But we don’t deduct this mostly because acquisitions are usually funded by debt or equity. Sometimes, tuck-in acquisitions may be funded by cash flow, but they’re usually one-off events.
DIVIDENDS: Found in the Statement of Cash Flows – Cash Flows from Financing section.
We don’t subtract dividends to arrive at Free Cash Flow. We assume this is money back to shareholders anyway.
SHARE BUYBACKS: Found in the Statement of Cash Flows – Cash Flows from Investing section.
Same reasoning as Dividends.
FREE CASH FLOW: Calculation
This is the big cheese. This is what we’ve worked so hard for. This is an approximation of the value that the firm generates each year.
Like a Bond.
The main advantage of using Free Cash Flow is that it’s a cash number. There is no ambiguity about it. This is miles better than using Earnings or Net Income, which is an Accounting number. What does that mean? Accounting numbers involve several assumptions about future (potential) cash inflows and outflows due to taxes and interest payments that are capitalized and amortized to “smooth out” earnings. This isn’t manipulation. It’s actually playing by the rules such as the US Generally Accepted Accounting Principles. The problem is that there is a lot of subjectivity in the assumptions behind these accruals. It makes the Net Income number almost irrelevant. Yet it’s still widely used, which confounds me and confounds Buffett.
“Buffett considers earnings per share a smoke screen…To measure a company’s annual performance, Buffett prefers return on equity—the ratio of operating earnings to shareholders’ equity.” – from The Warren Buffett Way by Roger Hagstrom
Buffett likes to use something he calls “Owner’s Earnings”. This is very similar to Free Cash Flow. Here’s how he does it:
Owner’s Earnings =
+ Depreciation & Amortization
+ Other Non-Cash Charges
Minus Capital Expenditures
Ultimately, this ends up looking a lot like Free Cash Flow as calculated by The Buylyst. But there are some differences:
- We also deduct Cash Paid for Interest.
- We also deduct Cash Paid for Taxes.
- We go at it from the top – from Revenue – because that’s more intuitive to us.
- Ours is a bit more conservative.
The concept of Free Cash Flow is very bond-like. In fact, the cash waterfall you saw above is a re-incarnation of the type of waterfall I used as a High Yield Bond Analyst. When we use Free Cash Flow to value a company, we’re essentially assuming that we get annual “coupons” every year. In bond valuation, these coupons are fixed. Hence the term “Fixed Income”. In this case, our Free Cash Flow won’t be fixed. At The Buylyst we assume an “average” number because nobody – not even Buffett – can predict the exact Free Cash Flow number. We go with something Sustainable.
However, even if it’s Sustainable, it must still be discounted to the present value. This is a whole another can of worms. And what many investors don’t know (or ignore) is that Buffett uses a totally different (and simpler) methodology compared to most of the “market”.
For the sake of sanity and brevity, I will leave Discounting and Cost of Capital for the next worldview article in this series. Coming Soon!